Scott Pfeiffer's Business Blog

Category Archives: Entreprenuerialism

Entrepreneurs must understand the different types of intellectual property and how to protect each type. Entrepreneurs should then take action to protect their intellectual property as soon as possible – before launch is best.

Protectable intellectual property includes patents, trademarks, copyrights, and trade secrets. Each of these categories protects a different aspect of your ideas. In this article, I will only discuss how to protect your intellectual property in the United States. The laws and schemes of other jurisdictions will vary.

Patents protect useful inventions that solve a specific technological problem. In return for disclosing your solution to that problem (the solution may be a product or a process), you are granted exclusive rights to exploit the invention for a period. After the patent expires, anyone can use the invention.

Trademarks protect the brand names, logos, and slogans you use to sell your product. A trademark grants you the exclusive use of the name, logo or slogan you use, and permits you to stop anyone else from using a name, logo or slogan that is confusingly similar.

Copyrights protect your original artistic or literary works. Like patents, the copyright gives the author certain exclusive rights to use or exploit the copyrighted work for a period.

Trade Secrets are business information, processes, practices, formulas and the like that a business owner has chosen not to patent and that the business owner seeks to protect by limiting access to them. Trade Secrets are secret as long as you can protect them. Business owners use laws like the Uniform Trade Secrets Act (in most US States) to help them protect their trade secrets.

Entrepreneurs should take the time – up front – to determine what intellectual property they have and to protect that intellectual property.

For inventors, patent registration is imperative. Not only must your invention be novel and useful, but also you cannot patent an invention once it has been publicly disclosed. Therefore, patenting your product or process is not something that can be put off until later. You apply to register your patent at the United States Patent and Trademark Office. Before you register, you or your patent attorney must conduct a thorough patent search. You may also need professional drawings and detailed specifications. Patents are by far the most complex of the intellectual property schemes, and there are many options, including provisional patents, utility patents, design patents and plant patents. Unless you have considerable patent experience, you should get a patent attorney to help you with this process.

Trademark registration should be thought of as a mandatory, basic expense for almost any small business. You are going to be putting a great deal of time and money into growing your business’s name recognition in the marketplace. It always hurts when you have finally gotten some traction, and you get that nasty letter from some trademark attorney telling you to “cease and desist” infringing on their client’s trademark. At a minimum, you will be changing your name, possibly your logo, and losing all the traction you have gained in the marketplace. The fact that a state had allowed you to use a name when you formed your business does not give you a trademark. The fact that you were able to buy the ‘.com’ of the name does not give you a trademark. In either case, the trademark owner can come along later and make you change the name or give up the web address. Trademarks are obtained by filing a trademark application online at the United States Patent and Trademark Office. As with a patent, you or your attorney should conduct a thorough search first, and you may need a professional drawing if you’re trademarking a logo. You may be able to make it through trademark registration without an attorney, but an attorney who knows trademark procedure and has registered trademarks will be money well spent.

Copyrights are the easiest protection to do yourself. The forms are relatively simple, and if you are a person who can follow detailed instructions carefully, you can do it. One registers a copyright at the United States Copyright Office – a department of the Library of Congress. There are at least five different type of copyrights (literary, visual art, performing art, sound and serial). Sometimes, this can get a little confusing (a computer program is a ‘literary work’, for example), and a good copyright attorney can be useful. This is especially the case because there are often sticky issues of ownership, rights, licensure, etc. that surround a copyright. These issues create a fertile source of small business litigation – better get this right the first time.

A small business protects trade secrets by keeping the information confidential, by identifying what information you consider as secret (marking any document it appears in is a good way) and by including trade secret protection language in your employment agreements, your employee handbook, or your job offer letters, as the case may be. Trade secret law is local – each US State is different – unlike patent, trademark and copyright law, which is federal and the same in each state. Your business attorney should be familiar with your state’s particular trade secret law and how to best protect you.

Intellectual property gives your business value, and a well curated portfolio of intellectual property will impress potential buyers and make exit easier and more profitable. Protecting your intellectual property will also enable you to get full value from your thoughts and ideas, realize the benefits of your marketing efforts, and protect your investment from dead ends like infringement. The wise entrepreneur protects intellectual property up front, budgeted as a start-up cost, and does not put intellectual property protection off until later.

Entrepreneurs create and grow businesses. Eventually, most will want to exit that business, at least partially. Perhaps your dream is to sell your company to a third-party. Perhaps you want to be able to sell the company to a key employee, or even to have your children buy the company from you. Perhaps you just want partners to buy in and take some of the burden off your hands. Unless your goal is just to shut the company down when you’re done, or to give the business to your children without taking any significant cash out for yourself, you will want your company to have value.

Companies don’t just intrinsically have value.

You have to work intentionally to create value.

Creating value is not something that happens overnight. Creating real value in your business takes time – a few years at least – and to be successful you need to understand what factors prospective buyers or investors and their professional advisers (especially their lenders) will be looking at to determine your company’s worth (let’s just call all of them ‘buyers’ for the rest of this article). The first thing you should note is, when these buyers start looking at your company’s financial and legal information, they are not going to look just at the present year and your projections. The buyers are going to be looking at historical data – 3-5 years at a minimum – and they are looking for trends and for evidence you have done something to artificially improve the company’s financial picture just before the sale. The buyers will look at historical data because it is harder to fake several years.

As an entrepreneur who wants to realize value for your business, then, it is imperative that you start building value early. In any case several years before you think you will want to sell your company or otherwise get some of that value (my friend Brad Cunningham calls it ‘taking some of your chips off the table’. Brad, in addition to being a successful serial entrepreneur, is a poker player).

Here, then, are my top ten ways for entrepreneurs to begin to create that business value now:

Show a Profit. Your tax adviser will disagree, but this is the most common mistake entrepreneurs make. Small business owners reduce their annual profit to zero every year and are shocked when they are told their company isn’t worth anything.

Focus on Revenues. It isn’t all about the bottom line – the top line matters as well. Buyers will want to see consistent gross revenue increase over time. You can’t get comfortable – if you want to sell eventually, you must continually grow those revenues.

Maintain Good Corporate Records. Whether you will eventually sell assets or your company as whole the buyer will be buying from your entity. Most likely, you own either a limited liability company or a corporation. Make sure you have all your corporate records in good shape early.

Protect Intellectual Property. All businesses have intellectual property, even if it’s just a trademark for their name or slogan. You may also have copyrights or patents. Act early to actually file for formal registration of all your intellectual property.

Keep Contracts up to Date. Most businesses will start with some contractual relationships – with suppliers or vendors or customers or landlords or tenants or contractors or employees or even with owners. Someone in your organization needs to have all of your contracts organized, available and kept up to date, and make sure they are renewed when they expire.

Attract and Retain Good Employees. Companies don’t make things, sell things or perform services – people do. If you want your business to have value, it must have good people. Nothing will sour a deal faster than the buyer getting the feeling that employees are unhappy, disgruntled or unproductive. Treat your rank and file well and make sure key employees are not only happy and well compensated but also that you have protected the business with reasonable employment agreements.

Identify Customers. In some businesses, this one is easy – you may have only a few large customers. Often, though, you may have many customers, hundreds or even thousands. A buyer is going to want information on your customer base and buying habits. You should take steps to identify customers, track their spending and habits, and nurture relationships with key customers if you want to build value.

Professionalize Management. There comes a point in the life-cycle of the start-up where the founder (or founders) cannot do it all anymore. You must make the transition from entrepreneur to CEO, and hire some key employees to take over key management tasks. You go from doing it all to managing those who do it. This can be a tough transition, but to realize significant value from your business, it is a transition you need to make.

Replace Yourself. The last step of professionalizing your management is to make the final transition from CEO to owner. You may not take this final step before you sell, but you should be prepared to. If you can demonstrate to a third-party buyer that you have a successor CEO already trained and in your business, you open the door to potential buyers that want to buy a company, but not a job. If you are selling to a key employee, you need to be able to show that employee’s bankers or backers that he is up to the task of filling your shoes. If you can’t do this, be prepared for a buyer to demand that you stick around after the sale as an employee – exactly what you became an entrepreneur to avoid in the first place.

Know Why You’re Leaving. I learned this last one from Brad Cunningham, who has successfully grown and sold several businesses. Brad says he is always asked why he is selling and getting out, and that his answer is important. The buyer wants to know you’re not a rat jumping off a sinking ship – especially if you are selling before you’re over 65. Being clear on this answer will also help you deal with the almost inevitable post-deal blues.

The Exit Strategy. It may seem odd to put last things first, but it is hard to have a successful journey together if you haven’t agreed on where you are headed. Solo entrepreneurs need to know their intended exit as well – it will help them make consistent decisions that uniformly move the company toward the intended goal – but for partners it is imperative. Many of the decisions you will make together as you go forward, about raising capital, salaries, employees, loans, expansion, dividends, accounting, capital investment, all will impact the viability of the exit. Know where you’re headed together and you reduce the number of fights over these issues dramatically.

The Governance Model. Agree up front on how hard decisions will be made. Early on, there is likely to be a lot of agreement. Everyone is excited and getting along. Do not fool yourself – there will be times ahead where you do not all agree. How will you make decisions when you do not all agree. There are several viable decision making models – and a good business attorney, business consultant, or mentor can guide you through the choices – but you should agree on a model up front, while everyone is getting along.

Pro Tip: You must make sure your legal governance document (Bylaws and perhaps a Shareholder Management Agreement for a corporation, an Operating Agreement for a limited liability company, a Partnership Agreement for a true partnership) reflect the governance model you have chosen. Too often attorneys simply draft a boilerplate agreement and the voting and duties provisions in that agreement do not match what the partners are actually doing. This can be a very expensive mistake. Take the time to go through the governance documents, all together, with your attorney, and make him put those provisions in plain English you all understand.

Adding Partners. Will the initial group of partners be the only permitted owners, or do you plan to expand? Can spouses or children become owners? Will key employees be offered ownership? If the answer to any of these questions is ‘yes’, or even ‘maybe’, you must agree now on a fair mechanism to handle these important events. What vote is required? How is the buy-in price determined? How are the votes redistributed (hint: you have to know your governance model before you can answer that question). Once the actual situation comes up, it will be nearly impossible to come up with a fair system, because each partner will have a stake in the outcome of that particular situation. Better to put a system in place before a real world decision needs to be made, and then follow the system when the situation arises.

Caution: The decisions whether to allow spouses or children to receive, be transferred or inherit shares and become partners can be a difficult one. Partners who get along with each other may not get along with their partner’s spouse, or be impressed by their partners’ children. These discussions can be emotional and must be handled with care, but that is all the more reason to have them and have them before the issue arises. There are several ways to handle this issue – including allowing spouses or children to receive or inherit non-voting shares that allow them to benefit economically without participating in governing the company, but in those cases the non-voting partners’ rights to records and information must be carefully spelled out.

Capital. Agreements on capital is more complicated than just agreeing on how much money each partner must put into the business at the start. Small businesses must be flexible, and there are a variety of capital needs that may arise. You must be prepared for all of them. If the company needs more capital, for example, can the partners be forced to put in more money (a ‘capital call’, and what happens if a partner cannot, or will not, meet a capital call? Often, partners meeting a capital call can get extra voting and profit rights over those who fail to meet a capital call. Take care, however – in a partnership where some partners have significantly more personal financial resources than other partners, this can be used to squeeze partners out unfairly. The mechanism for calling in capital and handling failure to meet capital calls must be carefully crafted based on the makeup of each particular partnership. Capital can also come from third parties – in the form of investors or lenders. These eventualities must be planned for. If the company decides to raise capital by selling shares, will partners be permitted to buy shares themselves and increase their own voting and profits rights (so called “preemptive rights”). If the company decides to raise money by borrowing, must partners agree up front that they will sign a personal guaranty (almost a given in a start-up) and is there a penalty if a partner does not sign a personal guaranty? Work these issues out up front.

Personal Exits. The only constant in this world is change. You may all agree on the exit strategy and you may all be committed to the company at its inception, but your plan must allow for that to change. Someone may want to leave. Maybe they are not happy. Maybe their spouse got a job in another city and they have to move. Maybe they die, or become disabled. Maybe they want to retire. Maybe they just want to go teach, or join the Peace Corps. Whatever. The more partners you have, the more likelihood someone wants out, or is forced out, before you expected. A good agreement covers these situations. Know up front that these are probably the most emotional decisions that your partnership will face. It is critical to have a detailed plan for handling these situations. Is someone who is leaving allowed to sell their shares? To whom? Must they offer the shares to the company or the other partners first? Must they, instead, leave their capital in the business until a certain term expires (common in LLC’s)? If so, how is that to be handled? If the company is to buy back their interest, how is the price determined and how will the company pay for it – insurance? Over time, and on what terms? Will there be a non-compete? Do different exits trigger different terms? If you do not have an answer to these questions, you are likely to find that a Judge will be providing them for you. Expensively.

Bonus Tip: Intellectual Property. Does your partnership have intellectual property? Sure it does. Trademarks. Copyrights. Patents. Most companies have at least some of these. More importantly, some companies – like tech companies – have copyrights or patents the author or inventor of which is one of the partners. In this case, it is absolutely essential that the ownership and rights to the intellectual property be spelled out from the beginning. Some of the most titanic struggles I have seen have been between former partners who did not agree, clearly and in writing, up front, who would own the copyright on a software program or the patent on an invention. Decide up front. Get the help of a competent intellectual property attorney to formalize your decision properly. Save yourself a giant headache later.

These are not the only areas where agreement up front can help smooth the path for a potential business partnership. Partner time and duties, growth and expansion plans, partner compensation formulas, employee management issues, record keeping and record access, and competitive advantage are all areas where open and early discussion is merited. If you can discuss and agree on these five, though, you will be far ahead of the bulk of your contemporaries, and on your way to a successful partnership venture.

Europe emerged slowly from the Dark Ages that followed the fall of the Roman Empire. Trade during that time virtually ceased. Growth was stagnant. Most people rarely traveled more than a few miles from where they were born.

As Europe revived, trade across regions began to blossom. Intrepid merchants traveled across Europe and returned home with new products. Locals began producing excess goods and selling them to merchants for trade. In the beginning, these new businesses – traders and producers – were family affairs. It was rare to have a business partner that was not a close family member.

Over time, however, businesses grew and the family was no longer able to produce all of the partners needed to make the enterprise run. The Company was created, and it became more common for non-family members to become owners of the enterprise.

The term company itself reveals the enterprise’s family origins. The word “company” is derived from the Latin “cum panis” – “with bread”. A member of a company is your “companion” – someone you share bread with. The new partners, not bound by ties of blood, were chosen very carefully, and became like family – permitted to take in the hospitality and protection of the home, symbolized by the sharing of bread.

Today most business enterprises are still owned by a single individual. In 2000, there were 27.2 million business tax returns filed with the Internal Revenue Service. Of those 27 million enterprises filing returns, 17.9 million – 66% – were sole proprietorships. Widely held, publicly traded firms made up less than one percent of enterprises. The remainder, about 32%, were closely held businesses owned jointly by a small group of people, often not in the same family. True companies.

There are many advantages to the company over the sole proprietorship. Companies allow entrepreneurs to get more done – spreading out the work of the firm among more owners. Companies allow for more entrepreneurial talent to be added to the firm, with each partner bringing a unique set of skills and perspectives to the group. Companies spread financial risk, with more partners to put in capital or guarantee loans. While many of these can be done by adding employees, an employee rarely has the loyalty and buy-in of a partner.

The family-owned businesses of the late middle ages found that non-family owners were needed to expand the business into new areas, and to access new talents. The same can be true today. Those early companies were careful about who they added, though. New partners became a part of the family, and were selected with great care. If you are an entrepreneur or professional operating a sole proprietorship or a family business, and you are thinking of offering ownership interests in your firm to non-family members, you should consider the wisdom of those earlier business pioneers, and take such a course of action cautiously.

Here is why:

1. Time. You are going to be spending a great deal of time with this person, and in a more intimate way that if they were your employee. You will be sharing more of your thoughts, hopes, dreams and finances with this person than with most any other. Make sure you like the person you are partnering with enough that you don’t seek to avoid spending this time with them – over time that will cause major problems in your business.

2. Privacy. Most people tend to be very private about certain things, like finances. Talking frankly about money can be hard inside a family, and can be harder with non-family members. As business partners, you will have to openly and frankly discuss the company’s money and how to spend or save it. You will also need to trust this person with some sensitive financial and personal information. If they have a history of business relationships gone bad, you will want to proceed with caution.

3. Control. Entrepreneurs are, quite often, control people. You became an entrepreneur because you wanted to be in control of your own destiny – to call the shots. Taking on a partner means losing some of that control. Make sure you are comfortable with some level of collegial decision making and that you are prepared not to get your way all the time.

4. Divorce. When spouses split, they go through a divorce. When business partners split, there is the business equivalent of a divorce. Like real divorces, they can be amicable, but they are never fun and quite often they end up acrimonious and in court, with lawyers.

Partnering has great advantages for a small business, and for many entrepreneurs it is an excellent way to grow. Solo entrepreneurs often reach a point where they just can’t do any more, and bringing in partners is often a preferred method of growth over professionalizing management too early. Choosing those partners wisely, and engaging in some frank up-front planning will help keep you and your new partners happily breaking bread together for years to come.

You are an Entrepreneur. You have to be good at what you do. You must provide your core service, manufacture your core product, or sell your core goods, effectively. Just being good at what you do is not enough, however. As an entrepreneur, you must also be good at managing the business of what you do.

A key part of managing the business of what you do is understanding your business’s finances. I wrote before about the four basic financial statements, what they are and how they relate to one another. I will be writing about the Profit and Loss Statement and the Balance Sheet in more detail soon. First, though, I want to write about some basic financial terms that every entrepreneur must know.

Balance Sheet Terms. You balance sheet lists all of your business’ assets, liabilities and equity on a particular date. To understand the balance sheet, you must understand:

Assets. Assets are all of the things with a monetary value the company owns: Cash, securities, accounts receivable, inventory, land, buildings, vehicles, furniture, intellectual property. Assets are generally things that can be sold to somebody else.

Liabilities. Liabilities are the debts of the company: Money owed to suppliers (trade debt), debts owed to banks or other lenders (notes),accounts payable, taxes due. Anything the company owes to someone else that must be repaid is a liability.

Equity. Equity is the net asset value of the company to its owners at any point in time. Equity reflects the amount the owners have put into the company (unless an owner made a loan to the company, which is a liability), plus retained earnings, or minus retained losses. On a balance sheet, the Assets always equal the Liabilities + the Equity. That’s how the balance sheet ‘balances’. To calculate your company’s Equity, then, you subtract the Company’s Liabilities from its Assets.

Debt to Equity Ratio: Your company’s debt to equity ratio is calculated by dividing the Liabilities by the Equity. A company with $1,000,000 in Assets, $750,000 in Liabilities and $250,000 in Equity (remember, Assets = Liabilities + Equity) has a debt to equity ratio of 300% (meaning that creditors are providing 3 times more to the company than the shareholders). Lenders and investors care about the debt to equity ratio – the more debt you have in comparison to your equity, the less likely you are to attract a lender or investor.

Debt Ratio: Your company’s debt ratio is calculated by dividing the Liabilities by the Assets. The same company as above, with $1,000,000 in Assets, $750,000 in Liabilities and $250,000 in Equity (remember, Assets = Liabilities + Equity) has a debt ratio of 75%. The higher the debt ratio, the more “leveraged” the company is. Debt ratios vary widely across industries, with capital-intensive businesses such as utilities and pipelines having much higher debt ratios than other industries like technology.

Profit and Loss Statement Terms. The profit and loss statement (also known as the P&L, or sometimes as the Income Statement) lists your company’s sales and expenses over a defined period (a month, a quarter, a year) and is used to work out the gross and net profit of a business. To understand a P&L, you must understand:

Sales. The money your company receives in exchange for its goods or services. Also called Revenue. On a cash basis P&L, this is money your company has actually received. On an accrual basis financial statement, the sale happens and the revenue is booked when the goods or services are delivered, whether or not there is immediate payment.

Cost of Sales (also called Cost of Goods Sold). This is the cost of the raw materials and assembly of what your company sells, or the cost of the finished goods your company resells, or the direct costs of delivering the services your company delivers. This is what a manufacturing company pays for raw materials, what a bookstore pays the distributor for the book they sell, what a construction company pays a laborer for providing direct labor on a project, or a law firm pays an associate or paralegal for work on a client’s legal matter. Costs of Sales are the variable costs incurred only if a sale is made, rather than the fixed costs (rent, administrative salaries, interest payments) your company incurs whether a sale was made or not.

Gross Profit (also called, confusingly, Net Revenue). This is simply Sales – Costs of Sales. It is the profit the company has after paying its direct costs of sales, but before paying any expenses.

Operating Expenses. Office rent, administrative and marketing and development payroll, telephone bills, Internet access, all those things a business pays for but doesn’t resell are operating expenses. Taxes and interest are also expenses. Expenses include non-cash items, such as depreciation and amortization, but do not include payments that are not deductible from income, like dividends to shareholders or the repayment of the principal amount of a loan. The fact that the Profit and Loss Statement does not include some cash transfers (like the money the company gets when it borrows, or the money the company pays when it repays the principal of a loan) and the fact that the Profit and Loss Statement does include some deductions from profits that do not involve cash (like depreciation and amortization) is what differentiates the Profit and Loss Statement from the Cash Flow Statement.

Fixed and Variable Cost: A variable cost is a cost that changes depending on the number of goods your company produces or the amount of products or services your company sells. Examples of variable costs are raw materials used in making your product, direct labor (labor costs you only incur in making a sale, like an hourly rate job that you service by paying a subcontractor by the hour), shipping costs, sales commissions. Variable costs are those which you only incur if and when you make a sale today. Fixed costs are those which do not vary by sale. They remain the same regardless of how much is sold (until you change them yourself by renting a bigger building, hiring more employees, etc.) Examples include the salaries of employees that are not directly tied to revenue – employees that are paid the same salary each month whether they sell more or less goods and services; rent and other overhead that is not included in cost of sales; phone service, insurance, utilities (your utilities might go up or down somewhat based on your sales volume, but the bulk of your utilities cost as not revenue dependent – the lights stay on and you heat or cool the office regardless of sales. For this reason, utilities are generally considered a fixed cost. Variable costs are generally booked as Costs of Sales, and Fixed Costs are booked after Gross Profit as Operating Expenses.

Break Even Analysis: Possibly the most important calculation the beginning entrepreneur will make is the break-even analysis. To make the break-even analysis, you must have a good handle on your fixed costs versus your variable costs. The break even analysis tells you what Gross Sales you must generate in order for your Net Profit to equal zero. In other words, how much revenue do you need to break even?

To calculate the break-even point, you have to first identify your variable expenses, and then calculate a cost per unit ratio: this is the average percentage of costs of sales per dollar of revenue. If you are a game store that resells games you purchase from distributors, and you generally mark your product up 100%, and you don’t pay commissions or have any other direct costs of sales, then your cost per unit is $.50/$1.00. In other words, you make fifty cents Net Profit for every dollar of revenue.

Next, you must calculate your total fixed costs: how much are you paying each month (quarter, year) in fixed expenses that do not vary based on sales. Rent. Salaries. Utilities. Insurance. Phones. Interest. You are looking for a total dollar amount per period.

Finally, divide the total of your fixed costs by the Net Profit per dollar, and you will determine break-even revenue. (Break Even Revenue = Fixed Costs/Net Profit per Dollar). If our game store has $10,000 per month in fixed costs, and earns $.50 per dollar in Net Revenue, the store’s break-even point of $20,000 per month in gross sales. Knowing this number is critical for your business, and you should not only try your best to calculate it before you open, you also should be refining it as you go.

Profits (and Losses). The “bottom line” of the Profit and Loss Statement is the Net Profit or Loss. Simply put this is your total Sales minus Cost of Sales minus Expenses. If someone asks you, “what’s your bottom line”, this is your answer.

As an entrepreneur, you don’t need to be an accountant (although you should have an accountant). You must, however, understand basic finance and able to talk intelligently to shareholders, creditors, lenders, board members, and business partners about your company’s financial health. You must also be familiar with the basic financial tools you can use to measure and monitor your company’s financial help. Knowing these terms is a good start.

Financial Statements are records that present your business’s financial activity in a clear and concise way. It is important for entrepreneurs to understand the different records that make up the financial statements and how they work. Properly used and understood, financial statements let you, the small business owner, understand and manage your own business more effectively, and help you present an accurate representation of the financial health of your business to important allies.

There are four documents that generally make up the financial statements of any business. They are:

The Income Statement (also called the Profit and Loss Statement or the “P&L”);

The Balance Sheet (more formally the Statement of Financial Position);

The Statement of Cash Flows; and

The Statement of Changes in Equity

Each of these tell the story of your business in a different way. Taken together, they should offer the whole picture.

The Income Statement is used to look at the business’s profitability. It measures and totals the business’s income from all sources, and then shows the business’s expenses. The final line of the Income Statement shows the business’s net profit (or loss) over the period measured. The Income Statement covers a specific time period: monthly, quarterly, year-to-date and annual statements are the most common. You can determine the period covered in the income statement’s title. An income statement entitled “for the month ended 3/31/2015” covers all income and expense incurred in the month of March. An income statement entitled “for the quarter ended 3/31/2015” covers all income and expense incurred from January 1 – March 31.

The Income Statement does not include money that may move in and out of the business that are not income or expenses. For example, if your business borrows money from someone during the period covered, that will not be shown on the income statement, because the money you get from borrowing is not “income” – it is not taxable. Similarly, if your business paid some of the principal of a loan back during the period covered, it will not be shown, because the repayment of a loan is not an “expense” – it is not deductible (the interest you pay on that loan, however, is an expense and is shown).

A final note about income statements is that they may be prepared on a “cash” basis or an “accrual” basis. Cash basis statements record items of income or expense as they are actually received or paid by the company. On a cash basis, you record income when you actually receive the money, and you record an expense when you actually write and send the check. Accrual statements record the items of income and expense when they are earned or incurred. On an accrual basis, you record income when it becomes owed to you (you complete the work and send the bill), and you record expense when you owe the money (you receive the goods or the service), regardless of when you pay.

The Balance Sheet is used to show a business’s assets, liabilities and equity at any given point in time. Balance sheets have a single date on them, and speak as of that day. Typically, one would present an Income Statement for a given period, along with a balance sheet for the last day of that period. An Income Statement “for the year ended 12/31/2014”, then, might be accompanied by a Balance Sheet dated 12/31/2014.

The Balance Sheet measures all of the business’s assets (cash, accounts receivable, inventory, equipment, property, etc.). Note that the balance sheet shows the depreciated value of those assets, and detailed balance sheets might even show the original basis (amount you paid, generally) of the item, and then show how much depreciation has been taken and show the net asset value (basis – depreciation). All of the values of all of the assets are the totaled as “Total Assets”.

The Balance Sheet then measures liabilities (trade payables, the principal amount of debts or loans owed, taxes owed but not yet paid) and equity (the value of all shares in the company plus any retained earnings). The total of all liabilities and equity together must equal the total of assets. In other words, assets balance with liabilities plus equity. That is why it is called a “balance sheet”, it must balance. Any increase in a business’s assets, without a corresponding increase in a company’s liabilities, therefore increases the company’s equity.

The Income Statement and the Balance Sheet are the two most commonly asked for and provided Financial Statements in a small business setting. The other two Financial Statements, though, are important to understand and can be used by the business owner to help better understand the business, even where they are not being asked for by outsiders.

The Statement of Cash Flows covers much of the same information as the Profit and Loss Statement – it covers items of income and expense for a certain period of time. The Statement of Cash Flows has two important differences, however. First, the Statement of Cash Flows is always a cash-basis statement. It measure the actual movement of cash in and out of the company. If the Income Statement was prepared on an accrual basis, the Statement of Cash Flows becomes critical to understand the company’s actual cash position at any given time. For example, if your company is owed a lot of money it has not collected, the Profit and Loss Statement (accrual basis) may show a healthy cash flow, when in fact the bank account is empty.

The Statement of Cash Flows may reveal a drought of cash and alert you to take action to get those bills collected, raise cash, or delay expense. The other important difference is that the Statement of Cash Flows includes movements of money that are not included on the Income Statement because they are not items of income or expense (receiving or paying loans, for example), and it does not include items that are on the Income Statement that do not involve actual movements of money (like depreciation expenses). In that way, the Statement of Cash Flows is a more accurate measure of the movement of cash and your business’s cash position even when the Income Statement was prepared on a cash basis.

Finally, the Statement of Changes in Equity looks specifically at the ways in which the “Equity” portion of the balance sheet changed over any given period. The Statement of Changes in Equity looks, like the Income Statement, at a given period of time, and measure the change in that portion of the balance sheet over that period of time. Assume, for example, we had a balance sheet dated 1/1/2014, and another balance sheet dated 12/31/2014. Imagine also that the Equity portions of those two balance sheets (the Share Capital and the Retained Earnings) was different. Some change had occurred to the equity over the period. The Statement of Changes in Equity for the Year Ended 12/31/2014 would explain, in detail, the reasons for those changes. The Statement breaks the reasons for the changes down into categories (changes in accounting policy or corrections from a prior period, issuing or redemption of capital shares, income, etc.).

The Statement of Changes in Equity is most often used in a small business setting where there are non-managing investors who want an easy to review document that details what has happened with their investment, without having to wade through all the other Statements to figure that out.

Financial Statements can be used by business owners to better understand their business and make decisions. Financial Statements are used by the business’s professional advisers to make legal, business and tax/accounting recommendations. Financial Statements are used by investors to decide whether to invest in your business or to monitor their investment. Financial Statements are used by banks and other lenders to decide whether to make credit available to the business. The ability to understand and provide accurate financial statements can be critical for small business owners. In future posts, we will look at these important documents in more detail.

You have the entrepreneurial spirit. You want to open your own business. You want to be the boss. For the prospective entrepreneur, franchising offers great benefits, but also comes with significant burdens.

“a franchise can make your dream come true”

Benefit 1: Know How: Franchises are generally created from successful small businesses. Business owners, who have spent years perfecting their business model, have taken that wisdom and put it into franchise-training programs. Not only will most franchisors teach you how to provide the core good or service involved, they also will teach business skills like record keeping, inventory management, accounting and employee management. Many prospective entrepreneurs already know how to perform the core task and have good business skills, and will not find this to be a great help, or may even find the mandatory business methods of the franchisor to be limiting. For others, however, the training programs and manuals are a significant advantage.

Benefit 2: Name Recognition: When you franchise, one of the greatest benefits you are buying is the name recognition – the trademarks – of the franchisor. All small businesses must develop a reputation for excellence, either in service, quality or price. When you purchase a franchise, you are buying that franchise’s existing reputation. This is a significant advantage. Earning a reputation takes hard work, time and money. A good franchise allows you to start with a name recognition and reputation for quality that most start-ups can only dream of.

Benefit 3: Advertising Reach: Most franchisees pay an advertising fee as a part of their franchise agreement. Sometimes this money is simply money the franchisee is required to spend; sometimes, this money goes into a regional or national advertising co-operative run by a committee of the franchisees; sometimes, this money goes directly to the franchisor for national and regional advertising buys. Whichever of these, or combination of these, your franchisor selects, the result is usually that your advertising dollars go farther and have a greater impact than the same money, spent by a single small business, would.
This combination of know-how, brand recognition and increased advertising reach is designed to let you get started quickly and move successfully through that early period where so many small businesses fail because they could not generate gross revenues fast enough. This is what makes franchising such an attractive prospect for many entrepreneurs. Then again, the many benefits of franchising have their own drawbacks as well.

“The wrong fit will turn your dream into a nightmare”

Burden 1 Cost: The primary trade-off for all these benefits is the cost. Franchises are expensive, not only at the beginning, but throughout the life of the business. Most franchises begin with an up-front franchise fee. This is an cost you just do not have if you start your own business from scratch. Franchises also generally come with a permanent franchise royalty, which is often 5-10% of your gross revenues. Added to the franchise royalty are recurring advertising payments of 1-3% of gross revenue. You may also have mandatory continuing training costs, store remodeling or signage costs, and other hidden costs or fees. You must carefully consider whether the name recognition or advertising reach of a particular franchise is likely to drive enough revenue to the business to compensate for the fees you will be paying. You may make more money off less revenue without the fees.

Burden 2 Control: One of the primary reasons entrepreneurs go into business for themselves is to have control over their business and work environment. With a franchise, you surrender some or much of that control to the franchisor. The appearance of the store, uniforms, what you can sell, when you can be open, where you are located, whether you can expand, how and when you can advertise, whether you can give freebies or support local charities – all of these, and more, may be controlled or restricted by your franchisor. If control is one of your motivations for opening a business, you should carefully explore how much control you are being required to surrender to any potential franchisor before deciding whether to go into business with them.

Burden 3 Exits: Exiting a franchise is often a time of great frustration. Selling a franchise is much tougher than selling any other small business. The rules for how to sell, to whom you are permitted to sell and for qualifying potential purchasers are complex and can be maddening. The fees and costs imposed by most franchisors are steep. Often, the most difficult problem is the time the franchisor requirements add to getting a deal done – which can kill potential sales. Trying to continue your own business life outside the franchise model can be even harder. Most franchises come with tough non-compete clauses that prevent you from leaving and starting your own new business and many franchisors are ruthlessly aggressive in enforcing them. Worst of all, some franchises come with a built-in 10-15 year expiration date and sometimes have no guarantee of renewal. Imagine the frustration of building a market for a particular franchisor for an entire decade, only to have them not renew the franchise to you and sell your business off to someone else or turn it into a ‘company store’.

Tip: Have an attorney review the franchise agreement for any such potential gotcha’s, and do some investigation into any potential franchisor’s reputation among franchisees as well as their history of litigation.

“Take your time to investigate any potential franchisor carefully”

For the right entrepreneur, a franchise can make your dream come true, but the wrong fit will turn your dream, into a nightmare. Take your time to investigate any potential franchisor carefully, and see if franchising is the right fit for you.